Credit Writedowns has made it clear how little will there is in Washington for substantive reform in financial services. But, let’s be more explicit in this post about what policy makers are doing. I will use the recent Citigroup TARP brouhaha and changes to the implementation timetable of accounting rules as the vehicle for this discussion.

Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.

Obviously, if these plans do not work out because the economy declines more than expected, we can always fall back to the more coercive, interventionist mode of nationalization. However, that is Plan B only – measures to be taken only if necessary.

I am confident these plans will work. We are already seeing some faint signs of recovery. Mind you, unemployment will continue to rise at a devastating clip. But, by the second half of 2009, we should see some many more signs of recovery and with all of these plans in place, the liquidity crisis will be recede into the past.

All actions by policy makers in the U.S. banking system stem from the views implicit or explicit in these paragraphs, namely:

The banking system is at the heart of our economy and large financial institutions are more important to the U.S. economy and our standing as a financial center than small institutions.

The status quo is not all bad. On the other hand, fundamental change is destabilizing, while incremental change is good.

We experienced what was mostly a liquidity crisis in finance; The U.S. banking system is fundamentally sound.

Government ownership and banks don’t mix.

Monetary and economic stimulus will be effective in the medium- and long-term, especially if asset prices stabilize.

Time is our friend; buying time recapitalizes banking through the back door.

So, the goal has been to end the banking system liquidity crisis first, right the economy again, and, once things are well in-hand, implement major tweaks to our regulatory system to prevent a repeat of this crisis. While this seems a reasonable strategy, it falls well short of what is necessary because it is predicated on flawed ideas.

But, before I get into those flaws, let me point out how these ideas manifest themselves in policy on Citi and on accounting. First Citi.

Citigroup has been at the center of every major crisis

Citigroup has long been one of the most venerated and largest financial institutions in the United States. As such, it has been at the core of every financial crisis for well over 100 years.

In 1907, when the panic which galvanized Congress to create the Federal Reserve System got out of hand, J.P. Morgan met only with a few banks and the U.S. Treasury Secretary to ‘save banking.’ James Stillman of National City was one of those.

After the stock market crashed in 1929, National City Chairman Charles E. Mitchell was vilified by Glass-Steagall creator Senator Carter Glass as most “responsible for this stock crash,” arrested by then Assistant U.S. Attorney and later New York Governor and Republican Presidential candidate Thomas Dewey (think Eliot Spitzer) for tax evasion to be later found not guilty, and investigated by the Pecora Commission for excessive pay and tax avoidance (sound familiar?)

After a long period of banking stability, Citi was again at the heart of another crisis when the Latin American debt crisis nearly bankrupted the institution in the early 1980s because of reckless lending to Latin American governments. Leading up to crisis, Citi Chairman Walter Wriston famously quipped “countries don’t go broke” when, in fact, they later did.

Citicorp almost hit the skids again in 1990 but was bailed out by Saudi Prince Alwaleed bin-Talal.

Why has Citi been at the center of all these events? Citi-haters would say because the company is rotten to the core. I say it is because National City/Citicorp/Citigroup has been one of the largest banking institutions globally for a long, long time. Citi has been too big to fail for longer than most of us have been alive.

So what about the latest Citi bailout?

So this history is the backdrop for the latest dust-up surrounding Citi’s preferential treatment by government. As I detailed yesterday, the Washington Post has learned that Citigroup is to receive favorable tax treatment in its exit from TARP. Is this fair? Of course not. Is it legal? I am no lawyer, so I can’t say but it does seem dubious to me. Is it right? Maybe.

This is the crux of the question surrounding Citigroup and all of the machinations used to support it since Lehman Brothers collapsed. As I see it, the question is threefold?

Is it right or legal for the executive branch to grant Citigroup a tax benefit? The answer to the ‘right’ part of this question is clearly no. Congress is hopping mad that the executive branch continues to usurp power by interpreting law in a way that gives it more power than was intended. They have already tried to restrict this power, but the executive branch continues to take unilateral actions that should be done only in consultation with Congress. The legality is another matter.

Is it right for the executive branch to grant Citigroup a tax benefit which puts it at an unfair disadvantage vis-a-vis its competitors? No. But, if you follow the logic I presented aboveregarding the importance of Citigroup as an institution, what other choices do we have? You could stop Citi from escaping TARP but then you would be sending a signal that it is weaker than Bank of America or JPMorgan Chase, which is what I said above that you don’t want to do. Once BofA got a green light, Citi had to a green light too.

Is it right for Citigroup to receive this tax benefit? Maybe. As I said yesterday, the intent of the law is clear; it is to prevent predators in the private sector from making tax-motivated acquisitions. And this is not what we have here. One could make a reasonable argument that taxing Citi penalizes it unfairly. I don’t have an answer here. I do know that having the Treasury and IRS just secretly grant this tax benefit without telling anyone is wrong. It is taxpayer money.

Here’s a video talking about the bungled Citi TARP exit and the new BofA CEO.

(video embedded below)

So that’s Citi. Now, what about accounting?

Accounting law subterfuge is part and parcel of the bailouts

The reason I bring up accounting is because the Citi tax benefit case revolves around accounting. The bank stress tests were done from an accounting perspective. And capital ratios used to determine if a bank is safe and sound depend on accounting. So accounting is at the core of the quest to restore the banking system to health.

Now, Citigroup is well-capitalized by standard accounting measures. This is true even after the TARP money has been paid back. But, as we just saw, there is more than meets the eye than just numbers.

Take the Financial Accounting Standards Board’s adoption of Statements of Financial Accounting Standards Nos. 166 and 167 for example. That’s a mouthful! Just yesterday, I received a notice from the FDIC that it had finalized the regulatory capital rule related to these two accounting edicts. They said:

The FDIC, working with the other federal bank regulatory agencies, developed this final rule to better align regulatory capital requirements with the actual risks of certain exposures. Banks affected by the new accounting standards generally will be subject to higher minimum regulatory capital requirements. The final rule provides an optional delay and phase-in for a maximum of one year for the effect on risk-based capital and the allowance for lease and loan losses related to the assets that must be consolidated as a result of the accounting change. The final rule also eliminates the risk-based capital exemption for asset-backed commercial paper assets. The transitional relief does not apply to the leverage ratio or to assets in conduits to which a bank provides implicit support.

The rule provides temporary relief from risk-based measures. Banks will be required to rebuild capital and repair balance sheets to accommodate the new accounting standards by the middle of 2011.

You probably will have to re-read this five times because it is mumbo jumbo designed to be opaque. What they are really saying is this: the FDIC doesn’t think now is a good time for us to apply stronger regulatory capital standards to American banks because, quite frankly, they can’t handle it.

Basically, these two accounting rules were to go into effect that required companies to put large off-balance sheet items back onto their books. The meltdown in off-balance sheet SIVs (structured investment vehicles) loaded up with toxic assets was a major contributor to capital losses at financial institutions in late 2007. The Citigroup $58 billion rescue of its own SIVs almost two years ago to the day was a major watershed event that led up to the panic.

The accounting standards people at FASB wanted this fixed. But, of course, taking assets onto the balance sheet requires more capital. And since the big banks with large SIVs are more capital constrained than they appear because of hidden accounting losses, this is a problem. What to do? Delay the rule change for capital requirements. Then argue that its not a capital constraint problem, but a lending problem i.e. we did this because every dollar in capital is needed now to increase lending not because we are worried about dodgy assets still on the books. It helps that this is the line that the banks are taking.

Just re-capping here, Citigroup, Bank of America, and Wells Fargo were the last three big banks allowed to leave the TARP program. They were allowed to do so because Treasury says TARP was a success and the banks are well-capitalized institutions. Meanwhile, the FDIC will not allow new accounting rules to come into affect that would make the banks look less well-capitalized.

If you sensed subterfuge here, you and I would be on the same page.

Look, I told you back in April what the story was when I predicted the Fake Recovery. The timing of the recovery was probably earlier than I said, but otherwise this is exactly what is happening in the economy and in the market.

You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the ‘green shoots’ because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares – at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well.

You may not like the methods. I certainly don’t. But, this is the route we have chosen and will continue to choose. And it will work until and unless we get a relapse in the economy that takes asset prices down with it.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

Can you just imagine your – or just about anyone’s – company being treated in this way by the IRS or other financial authority? If you are to run a tad short of capital on April 15th and can’t quite pay your tax bill, how long would you expect the Treasury Department to tolerate that, until they consider your return? Any longer than that? How many tax breaks are you likely to get?
And the business of using gamey accounting methods as a purposeful part of the crisis strategy, would they do that for you if you were in trouble financially and it might help?

You are right, Ed, to find yourself more comfortable with the double dip notion you’ve approached so cautiously over the last several months. And when it dips, all the legerdemaine in the world won’t stop it. At some point, what’s true objectively simply itself. And then, perhaps, there will be a different kind of accounting, a peoples’ accounting, an accounting where the numbers have to do with the length of one’s term in a penal colony.

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